Is Macy’s Cheap For Good Reason?

Among the retailers that have been beaten down in the last 6 months is Macy’s (NYSE:M). The stock made all time highs in July and has since fallen about 45%. The company has come out with a long list of excuses. Among them is warm winter weather and poor sales to tourists traveling to the U.S. The company is now making some investments that could damage the brand in the long run.

One of the company’s largest investments is in a new store roll out called Backstage. Essentially this will be a discount store where Macy’s can discount the merchandise that they can’t sell in their flagship stores. First of all, I don’t think you would come up with this strategy unless you have had a lot of inventory that hasn’t sold or you foresee that to be a problem. There are many high-end retailers that have gone down this path and today they all have more discount stores than traditional stores. Competition in this space includes Nordstrom (NYSE:JWN), Saks Fifth Avenue, and Neiman Marcus among others. All of these companies have more discount stores than flagship stores. Opening discount stores has proven to damage brand value. Just look at the brand destruction that happen at Coach (NYSE:COH) and Micheal Kors (NYSE:KORS). Both of these companies are down over 50% from their highs and continue to struggle. Although brand value is not quantified on the balance sheet, it is there. Macy’s said on their Q3 earnings call that they have seen a trend of customers leaving Macy’s and shopping at high-end discount retailers instead. It seems like the company is now willing to sacrifice its brand value in an effort to get back to positive comps which brings me to the next issue. Macy’s plans on opening an undetermined amount of Backstage stores within existing Macy’s stores but assumes that there will be little cannibalized sales. The strategy is to bring in an entirely new set of customers that will shop at Backstage. I think this will be an extremely challenging task.

Last July, Jeffery Smith of Starboard Value made a presentation on Macy’s at The Delivering Alpha Conference. He contended that Macy’s could be worth $125 a share because its real estate might worth as much as $20 billion. Macy’s does have some impressive real estate and it is valuable. $20 billion might be a stretch, but even if it is worth that much, there is one big problem. Macy’s would have to pay rent on all these properties which would be violently expensive. Rent for a high quality retail building runs on average between 7% and 8% of the real estate value of the property. Valuing the real estate portfolio at $20 billion would equate into about $1.6 billion of rent payments each year. Macy’s net income last year was about $1.5 billion so the company would struggle to turn a profit. Macy’s has stated that they do not think it would create shareholder value to monetize its real estate.

To be fair, the company is also making some moves that could be great for shareholders. They continue to invest in Omnichannel that has been showing strong growth. In addition, they purchased Bluemercury last February for $212 million and they will begin rolling those stores out in 2016. Last week they also announced that they will be closing 36 Macy’s stores that will save $400 million in SG&A expense and they will continue to restructure throughout 2016. The real estate portfolio continues to be a hot topic with investors. The company is doing a good job by evaluating the locations that are least beneficial or have unused space and they are selling them. These strategies may help but the current vision for the company is rolling out Backstage which could be disastrous.

With the stock being down 45% since July, the valuation looks to be cheap. The stock currently trades at a price to sales ratio of just 0.45. Macy’s is expected to make $3.75 per share in FY 2017. Using this estimate, the stock trades at a reasonable 10.3x forward earnings (That is if earnings estimates are right). When I perform a 5 year intrinsic valuation on the company I come to a $40 price which is only about 3% higher than it is today. However, this factors in the estimated reduction in after tax operating income for FY 2016 and assumes that it will continue to decline, just at a slower pace through FY 2020. All valuations are biased, but considering the direction of the company, I have doubts that customers will return. I think the writing’s on the wall that margins may never be as high as they have been the last few years and sales may continue to disappoint.

I want to own wonderful companies at fair prices just like Warren Buffett’s quote says. I want to find companies that have strong demand for their products and a sustainable competitive advantage. Macy’s doesn’t seem to meet that criteria. It is having trouble selling merchandise. They are currently being forced to discount their merchandise to sell it and they are closing stores. They have now decided that the next chapter of the company will be discount stores. This strategy might help in the short-term but I think long-term brand erosion is certainly possible which will keep me from owning the company.